Efficient Market Hypothesis - Essay Example

Efficient Market Hypothesis Efficient Market Hypothesis Efficient Market Hypothesis is an investment theory which says that financial market cannot be beaten and is informationally efficient. The belief is that it happens because stock market always effectively set share prices such that it always integrate and reveal all pertinent information. According to the theory of Efficient Market Hypothesis, stocks are always traded on fair market value in the stock exchange market and so it makes it almost impossible to either sell their stocks for overstated prices or buy stocks at undervalued prices. As such, it must be unfeasible to break the overall stock exchange market through market timing or expert stock selection, and the only solution to an investor for obtaining higher returns is by buying riskier investments. Efficient Market Hypothesis is divided into three types. These are strong, semi strong and weak. The weak Efficient Market Hypothesis theory says that prices on assets traded such as bonds, stocks, or property already show all past available information for public. The semi-strong Efficient Market Hypothesis states that prices in addition to reflecting publicly available past information also shows that prices constantly change to show new publicly available information. However, the strong Effective Market Hypothesis says that in addition to the above two types of information, prices also show “insider” information or hidden truths. Although Efficient Market Hypothesis is the foundation of the financial theory today, it is doubtful and highly uncertain. A large number of educational institutions are in favor of Efficient Market Hypothesis but an equivalent number of people are against it. For instance, Warren Buffet, an investor, has been beating the market for quite a long time now which is almost impracticable according to the theory of Efficient Market Hypothesis. Critics of the Efficient Market Hypothesis also draw our attention towards the event of 1987 and many as such when the stock price of Jones Industrial Average (DJIA) came down by 20% in one day as proof that stock prices can diverge to a large extent from their fair market values. There is also proof against and for strong, semi-strong and weak Effective Market Hypothesis. In an answer to the critics, the advocates of Effective Market Hypothesis claim that market efficiency does not ascertain complete certainty about the future but it is a generalization of the financial market which may be false sometimes. However in practical, market is efficient for purposes of speculation for almost all individuals. Share Price Determination Effective Market Hypothesis explains why prices change in stock markets and how these changes occur. Effective Market Hypothesis believes that none of the techniques of share price forecast and valuation is true and that no one can beat the market or outperform it. The theory holds the opinion that gaining from predicting share prices and their movements is almost impossible and very cumbersome process. The arrival of novel information everyday is the main reason for change in share prices. An efficient market is one where prices can adjust vastly and without biasness to the newly proposed information. The current price of stocks show all possible information at a given time period. As a result, one should not consider the prices too low or too high at a given time period. The price of securities is adjusted before an investor gets time to buy and sell and make profit from new information available. The sole reason for the survival of an efficient market is the strong competition among the investors to gain from the new information they obtain each day. The capability to recognize underpriced and over priced stocks is of high importance. It would allow the investors to buy some stocks at a lesser value or sell the others at above their original value. As a result, people spend countless hours in an effort to find out mis-priced shares. In reality, only a small amount of analysts are able to detect mis-priced securities and obtain profit from them. Consequently, people waste more money in detecting prices by using their time and resources than the cost of actual transactions. The best way to determine security prices under Effective Market Hypothesis is to build a trust upon market prices. All investments in security market are fairly priced means that investors obtain what they are paying for. You can not fool investors in a securities market. The price of a share shows the present value of its probable future cash flows, which includes many factors as in liquidity, volatility, and bankruptcy risk. On the other hand, prices are based rationally, which means that price changes are ought to be unpredictable and random. It is due to he fact that new information is highly unpredictable. Thus stocks prices are supposed to be following a random walk. That is the prime reason that Effective Market Hypothesis is also known as Random Walk Theory. (Jonathan Clarke, Tomas Jandik, Gershon Mandelker). How to Predict Future Direction of Share Price Movement? The future direction of share price movement can be predicted by using categorization proposed by Fama (1991) in which the efficiency of stock market is studied under return predictability, event studies and private information. Return Predictability, as the name indicates, studies the returns on stocks and shares. The role of filter rules is of outmost importance for Return Predictability. “Basically, a filter is an automatic instruction to buy a stock after it rises x percent above a recent trough and sell again after it falls y percent below a recent peak” (BUCKLE, M. J., & THOMPSON, J. L. (2004)). The rule implies that one has to identify the cycles from which you wish to make profits. The size of x and y percent is decided empirically using the past data. If the two filters are negligible or small, it means that a huge number of transactions will occur. This will identify future profits but will increase costs at the moment. If profits can be obtained by only studying and going through the past behavior, it could be expected that daily prices of shares would show a degree of sequential connection. Sequential connection is effective when a change in one day is followed by the same change in share price the other day. Though, it is possible that a change in one direction one day is followed by a change in the other direction the other day, which is price reversal. Filter rules can take up the former event into account but not the latter one. Most studies of sequential correlation have failed to realize the significant connection between share prices. Event Studies predict future prices by making use of events such as a merger of rise in profits. Event studies use a model to elaborate security prices and determine whether real price differs from theoretical price. Two types of Event Studies do not use this model. They are Stock Splits and Stock Dividends. In stock splits, stocks are divided into smaller values. Large numbers of shares are denoted in the smaller values and ostensible value of security does not change. Stock dividends take place when dividends are not paid in cash but are paid in stocks. The fundamental value of the company does not change in both cases. Private Information occurs when individuals beat the stock market and effective market hypothesis theory by predicting the future share prices themselves. Without the assistance of Effective Market Hypothesis theory or speculation websites, etc, these individuals are competent of predicting future security prices themselves by studying the norms of the share market. They are the ones who challenge the Effective Market Hypothesis. Bibliography BUCKLE, M. J., & THOMPSON, J. L. (2004). The UK financial system: theory and practice. Jonathan Clarke, Tomas Jandik, Gershon Mandelker. The Efficient Market Hypothesis M. JENSEN (1978). Journal of Financial Economics: Some Anomalous Evidence Regarding Market Efficiency BARREN FLUFFIT. Investment Trust and Unit Trusts HILARY COOK (2003). Money Talk: How to pick a Winning Share Fama, E. F., (1970) "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance. Mark, N.K.S., Philip, L., and Adrian, T., (2000) Research Method for Business Students, (2nd edn), England, Pearson Education Limited, Chapter 13. John, B.W., and Morgan P.M (2001). "Last Years Winners as This Years Picks: An Analysis of Recent Hindsight as a Mutual Fund Trading Rules?" Mark, N.K.S., Philip, L., and Adrian, T., (2000). Research Method for Business Students, (2nd edn), England, Pearson Education Limited, Chapter 13. Robert, G.B., and John, B(2001) "The Efficient Market Hypothesis- A Discussion of Institutional, Agency and Behavioural Issues", Read More